Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?

Jessica Wachter

NBER Working Paper No. 14386
Issued in October 2008
NBER Program(s):   AP   EFG

Why is the equity premium so high, and why are stocks so volatile? Why are stock returns in excess of government bill rates predictable? This paper proposes an answer to these questions based on a time-varying probability of a consumption disaster. In the model, aggregate consumption follows a normal distribution with low volatility most of the time, but with some probability of a consumption realization far out in the left tail. The possibility of this poor outcome substantially increases the equity premium, while time-variation in the probability of this outcome drives high stock market volatility and excess return predictability.

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This paper was revised on March 22, 2012

Acknowledgments

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